Volatility Rears Its Ugly Head

The 5.6% rise in the Dow Jones Industrial Average (Dow) over the past week seemed to signal that the worst of the market downdraft was over. But, another wave of renewed selling in the stock market and buying of Treasuries, which are considered safe haven during difficult times, occurred on Thursday. At one point, the Dow had fallen by over 500 points and the 10-year U.S. Treasury yield, which moves inversely to its price, had declined to 1.97% â€” its lowest yield in decades. The Dow gained back some of its losses later in the day and the 10-year Treasury yield rose back above 2%, but it is clear that investor sentiment had worsened yet again.

The news that sparked the market drop and scramble into Treasuries was an unexpected rise in weekly unemployment claims back above the 400,000 (it had fallen below that psychologically important level last week), the weakest Philadelphia Fed regional business conditions index since 2008, and a disappointing report on existing home sales. Those investors who fear the U.S. economy is slipping into recession interpreted these reports as confirmation of their views and acted accordingly. Furthermore, these disappointing economic reports arrived, in the absence of announcements that policymakers on either side of the Atlantic have arrived upon plans that will reduce debt in the intermediate term without adverse consequences for growth. Are concerns of a double-dip recession warranted? In our view, a recession cannot be ruled out, but a sustained period of sub-par, though positive growth is more likely. First, recessions are typically preceded by a credit crunch, often induced by central bank tightening. While many businesses and households have had difficulty obtaining credit in the past three years, just in July, banks reported to the Federal Reserve that they have been easing their credit standards on most major loans. Furthermore, the policymaking body of the Federal Reserve, meanwhile, signaled last week that it intends to keep short-term interest rates low until well into 2013.

Second, the corporate sector is healthy. Second quarter earnings for the S&P 500 exceeded estimates for the tenth quarter in a row and analysts have raised their revenue forecasts for seven out of ten sectors in this index over the past three months. The consensus among analysts is that corporate earnings will grow by 16.7% in 2011, with further growth expected in 2012. Third, while cut-backs in government spending at the federal, state and local government have dampened GDP growth in the last two quarters, and are expected to do so in future quarters as the massive stimulus provided in the last recession is withdrawn, both exports and business investment remain strong. Lastly, consumer spending, which represents over two-thirds of GDP, is holding up surprisingly well as evidenced by recent retail sales reports. The consensus among private economists is that GDP growth will remain positive, if disappointingly slow, in coming quarters.

What should investors do in this climate? Investors who need cash in coming months for a major purchase can hardly be blamed for seeking out investments that preserve principal, even at the cost of exceptionally low yields. But investors who have made major changes in the allocation of their core holdings after major sell-offs in the past, notably by selling stocks, have often been disappointed: they have often succeeded only in locking in recent losses. Still, it is natural to seek out those asset classes that tend to do better in times of slow or even negative growth. These include high-grade corporate and agency bonds, both of which provide a spread (or yield advantage) over Treasuries. For those investors reluctant to give up upside potential in the stock market, history suggests that higher dividend-paying stocks are appropriate: stocks in the top two dividend paying quartiles have outperformed within the S&P 500 in periods of slow (and even negative) growth in the past 50 years. High dividend-paying stocks will not ensure the preservation of principal, but, for companies with records of steady dividend growth, they do offer cash flow at an attractive price.

This information is compiled by Cetera Financial Group from source material obtained or provided by US federal and state departmental websites, equity index sponsors Standard & Poor's, Dow Jones, and NASDAQ, credit ratings agencies Standard & Poor's, Moody's Ratings, & Fitch Ratings, domestic and foreign corporate issued newswires and press statements, and from referenced compilations and index readings by Bloomberg Professional. The information is believed to be from reliable sources; however, we make no representation as to its completeness or accuracy. The information has been selected to objectively convey the key drivers and catalysts standing behind current market direction and sentiment.

No independent analysis has been performed and the material should not be construed as investment advice. Investment decisions should not be based on this material since the information contained here is a singular news update, and prudent investment decisions require the analysis of a much broader collection of facts and context. All economic and performance information is historical and not indicative of future results. Investors cannot invest directly in indices. This is not an offer, recommendation or solicitation of an offer to buy or sell any security and investment in any security covered in this material may not be advisable or suitable. Please consult your financial professional for more information.

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